Beating Inflation Could Get Even Harder

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LONDON — The markets have entered their usual pre-Fed quiet phase, ahead of decision day on Thursday.

“European shares and US equity index futures are inching lower,” theFT’s market report says.

It said the same thing when I read it early this morning, except the word ‘higher’ has been replaced by the word ‘lower’.

In other words, nothing much happening.

The markets tend to get like this ahead of a big Federal Reserve decision.

We should welcome it. Ignoring the noise is key to good investing. And it’s easier to ignore the noise when it’s quiet.

UK Inflation Back at Zero

Speaking of little noise, we learned today that the UK’s rate of inflation fell back to exactly zero in August, according to the consumer price index measure.

CPI is the inflation measure the Bank of England targets, aiming for 2%. The longer it stays on the floor, the harder it is to make a case for the BoE raising interest rates.

Interestingly, while CPI inflation fell back (slightly) to 0.0%, the more old school retail price index measure is in something of an uptrend, albeit a shallow one.

From five-year lows in March and April it’s climbed to 1.1% last month. Hardly heady stuff, I grant you, but the divergence is clear.

To the extent that the CPI figure is a true reflection of the change in purchasing power, this looks like welcome news for anyone whose income is indexed to the RPI (holders of index-linked gilts, for example).

On the face of it, their income gets a boost while the cost of what they buy has stayed flat over the last year.

A great result, right?

Not necessarily.

Much of that apparent boost in real income may be largely illusory, however. For the individual, it depends on what they actually spend their money on.

For example, the RPI gives greater weight to housing costs than the CPI (the latter, for example, excludes mortgage interest payments).

The exclusions from CPI are based on valid theoretical and statistical arguments – but that’s of little comfort to anyone faced with rising housing costs that make up a substantial part of their income.

The growing gap between RPI and CPI looks like it could in part be a side-effect of the housing boom. In February last year Bank of England economists estimated that the ‘wedge’ between the two measures will average 1.3 percentage points over the long run.

That’s up from 0.5 percentage points over the period 2005-2013 (RPI has always tended to be higher than CPI – it’s the growth in the difference that’s of interest).

The study estimated that housing costs, including mortgage interest payments, would contribute 0.6 percentage points to the ‘wedge’, double the contribution for the earlier period.

A Chance For Some Financial Repression

I wonder if the divergence between RPI and CPI, if it continues to grow, could present an opportunity for policymakers to engage in a bit of old fashioned financial repression.

If you’re not familiar with the term, financial repression basically means ensuring savers can’t beat inflation.

Why do that? Because when savers lose out, debtors win. And our government is one of the biggest debtors around.

The classic tools of financial repression include encouraging positive inflation, holding interest rates down below that level, and limiting the options for savers looking to maintain their standard of living.

As a thought experiment, imagine a world in which index-linked gilt holders continue to receive payments based on the RPI. Imagine also that the gap between CPI and RPI grows.

The government, which has to make the payments on those RPI-linked gilts, relies for its income on tax revenues. These in turn are influenced by prices throughout the economy – via wage increases, corporate earnings and myriad other channels.

I can foresee a line of argument that goes roughly like this: it is unsustainable to make pay-outs based on RPI when the economy’s capacity to pay taxes, as measured by CPI, is falling behind. So let’s stop indexing to RPI.

Bear in mind that, since March 2013, RPI data have no longer been designated as National Statistics. The official line is the measure is statistically flawed.

It may well be. But it presents an opportunity for an overhaul.

Call me a cynic (people did yesterday when I failed to be enthused by Jeremy Corbyn), but the Treasury rarely misses a trick when it comes to tilting things in its favour.

RPI could one day be replaced as the index of choice for investments that aim to track the cost of living. If it is, I don’t expect its replacement to do as good a job.

Staying ahead of inflation could get even harder than it is already.

Until next time,

Ben Traynor
for The Daily Reckoning, U.K.

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